The term financial risk is quite broad, encompassing all kinds of risks arising from various financial activities. It can be defined as the possibility that capital will not be repaid or lost due to poor management, fraud, and obsolescence. All business professionals need to understand how to manage and mitigate these risks to avoid losing money and investment. This article will explore what financial risk is in business, including its causes and types of risk.
What financial risk is in business?
Financial risk can be defined as the ability of a business entity to manage its debt while taking care of its financial obligations; it also involves the loss of property, assets, or income. A business with limited financial resources may face difficulties when it encounters any kind of loss because it won’t have enough funds to cover for it. This leads to financial problems and lack of liquidity which results in a major impact on the profitability and value of your company.
Causes of financial risks in business
In most cases of financial risk arising, there are two main reasons why they occur: lack of control and bad practice. These are explained below.
1. Lack of Control
Lack of control occurs when an owner takes no responsibility for the actions of his employees. For example, if you own a retail store, yet your employees are stealing, you cannot claim “lack of control”; since you are responsible for managing them. However, if you hire new employees who don’t perform well, you take some responsibility for ensuring their performance in the future.
2. Bad Practice
Bad practices happen when people follow improper procedures without thinking about the consequences. If you see an employee wasting time by opening multiple emails during work hours without considering the fact that he could get fired as a consequence, then it’s normal for you to hold him accountable. Of course, you should provide training to ensure he learns how to properly handle emails so that he can keep up with the latest processes and procedures.
Other causes of financial risks
1. Fraud – where fraudsters cheat or steal from other parties. Such acts usually involve misrepresentations or misstatements about products, services, or prices. Examples include dishonest salespeople, accounting staff, or bank tellers. When it comes to financial risk, it’s important to know who might commit fraud and what signs to look out for.
2. Legal Actions – sometimes, creditors and customers initiate legal proceedings against the owners when businesses fail. Any litigation could result in a huge financial burden, especially if the case ends up going into court many times before it’s settled. Therefore, every business owner must understand the potential issues and liabilities involved in any type of lawsuit.
3. Bankruptcy – If a business fails to meet its financial commitments, it could go bankrupt. Even if a business doesn’t go bankrupt, it could still experience financial distress (e.g., negative cash flow). A bankruptcy lawyer can help evaluate whether bankruptcy would be best for resolving the problem in such situations.
4. Mismanagement – failing to manage a business effectively could lead to more severe issues like insolvency, bankruptcy, or even closing down altogether. There are many examples of businesses being shut down due to poor management.
5. Inflation – inflation increases the cost of inputs used in production while decreasing the purchasing power of consumers’ wages. Many businesses struggle with inflation for several reasons, especially those operating locally (i.e., mom-and-pop stores) and medium-sized enterprises. The latter group experiences higher inflation levels than large corporations because they have limited resources and may not raise prices quickly enough to match rising costs.
6. Changes in legislation – over the years, consumer protection laws could negatively affect a business. For instance, if sales tax increases, consumers will feel less compelled to spend money on certain industries (such as clothing and electronics).
7. Poor marketing strategy – often, companies fail to put sufficient effort into improving their overall marketing strategy. When this happens, they become vulnerable to competitors with better marketing strategies.
8. Natural disasters and pandemics – these events cause tremendous damage to communities and economies. Businesses will also suffer financially when natural disasters strike. If a company has factories spread across different countries, it could lose revenue if one country is affected by a disaster. Similarly, global pandemic outbreaks can seriously harm a business, which means employees may need to take leave from work for a prolonged period.
9. Stock market volatility – the stock market influences all types of businesses, but small businesses tend to react most strongly to stock market fluctuations. An example of this is the dot com bubble burst. This caused many companies to collapse, therefore causing a dip in the economy. It’s critical to understand the impact of stock market downturns and the ways to protect yourself from them.
10. Political instability & uncertainty – political instability and economic uncertainty usually go hand-in-hand. Not only do governments face budgetary problems and change policies that directly affect the market value of shares, but there is also always a risk of war and other geopolitical risks that make life difficult and uncertain.
Types of Risks
There are several categories of business risks, but one common characteristic among them is that they affect the profits (value) of the company. The types of financial risks in business today are explained below.
1. Market Risk
Market risk describes situations where the price of an asset might fluctuate greatly due to supply and demand, leading to losses if it’s sold at lower prices. An example would be selling a product at a low rate, thus incurring more costs than expected. When conducting a stock market analysis, one must determine whether the price of a particular item increases or decreases since fluctuations result in losses.
2. Customer Relationship Risk
When customers are dissatisfied with products, services, or pricing, businesses lose profit and reputation. They also lose sales and become less productive. Therefore, customer relationship is another form of business risk in every organization. To avoid the risk of customer attrition, it’s important to maintain good relationships with clients.
3. Legal Risk
Even though legal risks aren’t considered as severe as those mentioned above, it still affects the success of a business in many ways:
1. It can cause costly litigation expenses.
2. It can make you liable for damages or lawsuits.
3. It can lead to criminal proceedings against your business.
It’s advisable to always seek legal advice from a reputable attorney before going into any risky situation. With this information, you will better prepare yourself for facing these risks in the future. You’ll never know what tomorrow brings unless you’re ready.
4. Reputation Risk
Your company’s reputation is an intangible asset that represents its overall image. Therefore, losing reputation causes huge losses. As such, it’s essential to have a high-quality reputation to sustain the long-term growth of your business. Your reputation depends on various factors like service delivery, customer satisfaction, brand awareness, etc., so it’s very important to invest time and effort into ensuring positive perceptions about your business.
5. Process Risk
Process risk refers to the possibility of unexpected costs. For instance, you incur additional costs doing something new and unfamiliar just because it’s required. These costs won’t appear beforehand, so it becomes hard to identify. One way to prevent process risk is through proper training, adequate planning, and establishing control measures. However, when employees are not properly trained or lack the necessary knowledge, this may result in mistakes, eventually contributing to higher costs.
6. Human Resource Risk
Human resource risk relates to hiring workers who do not fit their positions. This leads to conflicts within the team and creates a negative work environment. In addition, poor performance by employees affects productivity and sometimes results in accidents. Proper management of human resources is essential to reduce all kinds of risks in business organizations.
7. Information Technology Risk
Information technology risk comprises the threat of theft or loss of data and other sensitive systems files. Such problems include theft, hacking, and natural disasters. There are many ways security can be improved, such as using encryption software and firewalls.
8. Marketing Risk
Marketing risk refers to the possibility of a significant drop in demand, leading to low volume sales. This could happen if a product fails or people lose interest in it. Another problem occurs when a competitor launches an identical version of your product at a lower price, leading to lost market share.
1. Data Analysis
Data analysis is usually used as part of business intelligence (BI) to help managers see trends and patterns concerning their operations. This helps them make decisions more efficiently. A virtual credit card issuing could help having a clear overview of all different expenses, which then can be analyzed and broken down very accurately.
2. Customer Satisfaction
Customer satisfaction involves meeting expectations and providing value-added services. When customers feel valued, they are likely to provide recommendations and referrals to others. Thus, it increases your business’s chances of survival.
3. Business Continuity Planning
This practice focuses on reducing disruptions during a disaster, allowing companies to continue operating even when critical facilities undergo failure. A plan should address:
• The nature, severity, and timing of potential threats;
• What steps will be taken in response; and
• Who will take responsibility for each step.
4. Risks Management Through Strategy Formulation
Risk management in strategy formulation helps companies avoid unanticipated outcomes. It is especially useful in identifying potential pitfalls before implementation. The goal of risk management in strategy formulation is to define specific metrics that will help organizations track possible outcomes.
5. Risks Management Through Control Creation
Control creation helps companies limit risks and enhance opportunities through appropriate processes and guidelines. To minimize risks, create detailed processes that support organizational goals, standards, policies, regulations, and procedures.
In conclusion, financial risk in business is any unexpected outcome arising from inadequate planning or action. Moreover, IT risks arising because information technology assets are vulnerable to theft, unauthorized access, fraud, etc. These risks may threaten the success of your organization and lead to loss of profits, litigation costs, etc.